Wherein I Go Mosquito Hunting with a Howitzer

I guess James Kwak ate a bad oyster or two at the Yale Law School cafeteria this evening. He rants:

Further Proof That Nothing Has Changed

Overheard on the streets of New Haven, just ten minutes ago:

Two young women, almost certainly Yale undergraduates, are walking down York Street, discussing their efforts to get jobs as bankers.

Student #1: “Why does everyone want to go into banking?” [Note: When an Ivy League undergrad says "banking," he or she invariably means "investment banking," meaning underwriting or trading.]

Student #2: “We should advertise – ‘Being a lawyer is so much better than banking.’”

Student #1 (after a pause): “Seriously, everyone wants to go into banking.”

End scene.

Also further proof that no one does campus recruiting better than a Wall Street investment bank. Or do undergrads these days want to work in industries that are best known for torpedoing the entire economy through a combination of greed and incompetence (and abusing their customers along the way)?

At least, after the last twelve months, no one can claim that he didn’t know what kind of business he was getting into.

By James Kwak

I mean, seriously, Jim, what the fuck?

* * *

Let me respond to Mr. Kwak's apparently throwaway anecdote with a few of what I hope will be corrective observations.

First, unlike Mr. Kwak, I do not pretend to know what Yale undergrads mean by "banking" or "investment banking." But as a practitioner with almost twenty years in the business, I can most reliably assure him there is more to investment banking than securities underwriting and trading. Depending on which kind of investment bank we are talking about, its business can comfortably encompass not only these, but also mergers and acquisition advisory, restructuring advisory, corporate lending, leveraged finance, derivatives, structured finance, proprietary trading, and even private equity investment. These are all very different businesses, with different career paths, different duties and responsibilities, and different cognitive and personality requirements for individuals who might choose to enter them.

An individual who might make an excellent corporate financier is almost certainly incapable of being an outstanding trader, and vice versa. I should bloody well hope that any Wall Street recruiter worth his or her salt has identified the different career paths available at his or her firm for the benefit of the wide-eyed young undergraduates and clarified their different requirements. If not, they should damn well be fired.

Perhaps it would bolster Mr. Kwak's understanding if I were to draw an analogy with his current career path. Saying that investment banking consists solely of underwriting and trading is almost exactly analogous to saying the practice of law consists of no more than intellectual property management and environmental litigation. (Which, for those of you not well versed in the intricacies of the legal industry, is fucking preposterous.)

I don't know how current Ivy Leaguers think, Mr. Kwak (and I suspect you don't either), but if you're going to presume to talk about my industry in a public forum, I suggest you get it right.

* * *

Second, Wall Street investment banks do do campus recruiting better than anyone else, or at least they used to. Part of this can no doubt be attributed to the fact that successful investment bankers like me are devilishly charming, stunningly handsome, scathingly brilliant, and in every other respect fucking paragons of the best and brightest an Ivy League education has to offer. Of course, even those nattering nabobs of negativism like Mr. Kwak who would deny the preceding have to admit upon examination of the facts that Wall Street's recruiting efforts on university campuses have been massively successful for the simple reason that—for a certain type of Ivy League individual—these jobs are fucking awesome.

How so, you ask? Well, let me count (a few of) the ways.

For one thing, they are exciting.

Unlike, say, 99.6% of all other jobs available to a wet-behind-the-ears idiot in proud possession of little more than an expensive college degree, becoming an investment banker fresh out of college is a huge rush. Depending on what role they perform, new entrants just weeks into the job can participate in billion dollar underwritings, multi-billion dollar mergers, complicated cross-border restructurings, or devilishly complex trading programs, all the while possessing a level of experience formally known in the industry as "jack shit."

In what other industry, I ask you, can a 22-year-old who just stopped wetting the bed three weeks ago participate in a deal which runs for weeks on the cover of The Wall Street Journal or the Financial Times? To be sure, he is probably doing little more than making copies, getting coffee, and trying not to look as stupid and lost as he feels, but at least he is in the room. Contrast this, if you will, with a fresh McKinsey recruit tasked with interviewing shop floor supervisors to develop a human resources inventory for a ball bearing manufacturer in East Bumfuck, Illinois. Or a pre-law student who spends 80 hours a week in a windowless basement cross-checking sale-leaseback contracts for a patent dispute in Moldavia. On average, young investment bankers spend less time traveling that management consultants and more time sleeping than corporate attorneys. Plus, they get to tell their friends and family that they carried Bruce Wasserstein's bags. What could be better?

For another, investment banking jobs are challenging.

Excluding certain training programs for elite military units, there are few career choices available to a young person as emotionally and intellectually challenging as investment banking. The pressure is intense, the expectations of your bosses and clients completely insane, and you swim in a Sargasso Sea full of assholes who would as soon rip your head off as look at you. It is an environment, if you can survive it, that fosters an intense esprit de corps among your peers and immense personal pride in your own accomplishments. As such, it can be considered emotional crack cocaine to those hyperaggressive, intensely driven, super-competitive young psychopaths whose mommies and daddies have pushed them down the Deerfield–Harvard–Goldman Sachs path to Übermensch-dom from infancy.

Long gone are the days when investment banking was a quiet backwater for the idiot sons of wealthy WASPs. For decades now, socially ambitious families have been steering brilliant little Bobby and Sally toward positions at Goldman Sachs and Morgan Stanley as the pinnacle of social achievement. Bobby and Sally have drunk this goal in with their mother's milk. Surely you don't think a little recession or crisis is going to change that right away, do you?

And, finally, there is the money.

Surely I don't have to explain about the money.

* * *

Third, I really do take exception to Mr. Kwak's pusillanimous little swipe at my industry for "torpedoing the entire economy." Admittedly, several large investment and commercial banks utterly failed to cover themselves in glory during the recent crisis. I have said so myself, repeatedly, in these pages. However, notwithstanding Mr. Kwak's insinuation, investment bankers were far from alone in contributing to the epic clusterfuck we have just lived through. We had plenty of help from shortsighted and incompetent regulators, meretricious and ignorant politicians, and greedy and disingenuous investors, not to mention millions of ordinary Americans who apparently believed it was their God-given right to own a million dollar house and three plasma televisions, no matter how little money they made.

In fact, I think you might have to look long and hard to find someone who was not culpable in some way for what happened. I, for one, would not automatically exclude the other professional enablers of corporate and institutional idiocy in our economy: the management consultants and the lawyers. It is a well-known fact that Mr. Kwak's own alma mater, McKinsey, has been the strategic consulting firm of choice for almost every major Wall Street investment bank for decades. Bang-up job, Jim.

* * *

Anyway, I grow tired of shellacking Mr. Kwak's flimsy, ill-considered post with the Howitzer of Truth, so I will try to close on a more productive note.

For those youngsters still considering a career in investment banking, I would offer the following. On the positive side, the excitement, challenge, and relatively plentiful monetary rewards of a career in my business should remain. The fundamental nature of the business, and the need for our services in the economy, will not change. On the negative side—and diminishing somewhat the preceding attractions, at least for a time—the industry will shrink, and this will make it harder both to get and to keep a job. Some subspecialities on the trading side might disappear completely.

But if you are smart, aggressive, driven, and competitive, I can think of few industries better suited to your personality than mine.¹ (And, unlike elite military units, people rarely shoot at investment bankers. At least not yet.) You may not receive the kind of social admiration and approbation of your career that you and your parents were looking forward to, but the personal rewards of doing well in one of the toughest professions out there will remain.

And, in any event, you will always be able to sneer with impunity at the lawyers.

UPDATE: To his credit, James Kwak has removed the egregious crack to which I took offense, calling it "gratuitous," and replaced it with a more anodyne remark. I will let my comments stand, however, since his original swipe was of a kind with many of the ludicrous comments attending his post. It is also sadly symptomatic of a persistent knee-jerk tendency in the media and the populace at large to scapegoat investment banking for all our current troubles, whereas by my most recent calculations we can legitimately be blamed for only 16.27% of the crisis.

POSTSCRIPT: Some correspondents have taken exception to my apparent boosterism of entry-level career opportunities in investment banking. Should any of you be of like mind, might I gently suggest you reread my remarks with a more critical eye? You might detect a faint whiff of a commodity somewhat rare in these over-strident times: irony. Just a thought.

¹ Especially if you're a girl.

© 2009 The Epicurean Dealmaker. All rights reserved.

Cold Pastoral

Heard melodies are sweet, but those unheard
Are sweeter; therefore, ye soft pipes, play on;
Not to the sensual ear, but, more endeared,
Pipe to the spirit ditties of no tone:
Fair youth, beneath the trees, thou canst not leave
Thy song, nor ever can those trees be bare;
Bold Lover, never, never canst thou kiss,
Though winning near the goal —yet, do not grieve;
She cannot fade, though thou hast not thy bliss,
For ever wilt thou love, and she be fair!

...

O Attic shape! Fair attitude! with brede
Of marble men and maidens overwrought,
With forest branches and the trodden weed;
Thou, silent form, dost tease us out of thought
As doth eternity: Cold pastoral!
When old age shall this generation waste,
Thou shalt remain, in midst of other woe
Than ours, a friend to man, to whom thou sayst,
"'Beauty is truth, truth beauty,' —that is all
Ye know on earth, and all ye need to know."

— John Keats, Ode on a Grecian Urn

Enjoy your weekend.

© 2009 The Epicurean Dealmaker. All rights reserved.

Res Ipsa Loquitur

Subsequent to my recent half-hearted cudgeling of the Shaggy Horse of Shareholder Governance as an important contributor to the excessive pursuit of risky returns by publicly-owned financial institutions, my argument received overwhelming reinforcement today in the pages of the The New York Times Dealbook from the person of scarily smart and excessively erudite Delaware corporate jurist Leo E. Strine, Jr.

Not only did Herr Professor Doktor Strine take the heretofore only slightly bruised nag out back and decisively beat it to death, he skinned it, deboned it, rendered its fat for glue, and gilded its hooves into four rather fetching ashtrays for the Court of Chancery's waiting room. In short, in your Humble Correspondent's considered opinion, he nailed it.

In a nutshell, the Esteemed Vice Chancellor most assuredly does not agree with those who believe that all public shareholders were innocent dupes taken along for a ride by evil, greedy, grasping investment bankers and their bosses in the recent run-up to the crisis:

Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage.

He continues:

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather [than] durably.

This is consistent with my view, that public shareholders of investment banks, as a group, did not act to brake the risk taking of their employees at all, but rather encouraged and rewarded it, or—what is perhaps more pertinent—punished any executive who did not embrace such activity wholeheartedly.

* * *

What I find most interesting about Mr. Strine's remarks is the salient distinction he draws among the motivations and behavior of different kinds of public shareholder. To the best of my admittedly limited knowledge, this is the first instance I am aware of where anyone has focused on this issue to this extent. He draws from it some useful policy prescriptions:

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

Of course, this analysis and argument applies more broadly than just to publicly owned financial institutions. However, given the extreme sensitivity said financial institutions have proved to have toward excessive risk taking, and the genuinely calamitous negative externalities they have inflicted on society at large as a result, I think the Honorable judge's recommendations have particular force in their case.

In any event, I believe Mr. Strine's analysis should conclusively disabuse participants in the current debate over financial regulatory reform of two related notions. The first is the red herring that somehow stronger corporate governance by public shareholders over investment bank Boards and executives would have prevented the kind of reckless risk taking that brought these firms—and the global economy at large—to the brink. The second is the canard that all public shareholders are alike, and they all share the same interests and motivations.

Realizing that the second of these is false, and that Fidelity Investments and SAC Capital do not have the same investment timeframe and objectives as Aunt Millie or even the Ohio Teachers Pension Fund, would have a highly salutary effect on the beliefs and behavior of truly long-term shareholders.

If nothing else, getting Aunt Millie to realize she is the only one in the shark tank without a safety cage should do her a world of good.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part IV

Westley: "Who are you? Are we enemies? Why am I on this wall? Where is Buttercup?"
Inigo Montoya: "Let me 'splain. ... [pause] ... No, there is too much. Let me sum up."

— The Princess Bride

* *

EDITOR'S NOTE: This is the fourth and final installment of a multi-post treatise on investment banking compensation. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry;
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay; and
• Part III: Seed of Destruction, about risk factors and risk management in the industry

This post attempts to tie together the preceding entries and come to some sort of reasoned conclusions. Fasten your seatbelts.

* *
— Part IV: Darkness Calls —

We have covered a lot of territory already. Let me sum up.

Traditionally, investment banks acted as intermediaries or agents for wholesale capital markets transactions, not principals. As such, while they did perform services that exposed capital to risk, traditionally these risks were of short duration, relatively small, and very well contained. Risky activities such as these are concentrated on the capital markets (or sales and trading) side of the business, and consist of using the bank's capital on a temporary basis to facilitate securities issuance or securities trading by their institutional customers. Due to investment banks' privileged position at the nexus of market flows and information and their ability and inclination to trade rapidly in and out of positions, banks have historically been able to conduct such business pretty successfully using relatively small amounts of equity capital.

Because their business is designed to make money off the flow and volume of transactions in the marketplace, rather than off sustained price appreciation or direct investment, investment banks have a business model and a culture which focuses almost exclusively on chasing transaction fees, or revenues. Since markets are often volatile, and revenue opportunities are fleeting, there is an institutional bias within investment banks to chase and book revenue first and worry about consequences later. With its low fixed salary component and theoretically unlimited upside incentive bonus, compensation for revenue-producing investment bankers is explicitly designed to encourage this pursuit.

On the other hand, investment bankers historically were very good at managing their business risks. Capital markets risk used to be managed by senior partners who had been traders themselves, and who had complete visibility and understanding of the risks in the bank's trading book.¹ Encouraging and supporting this hands-on supervision was the fact that senior trading partners typically had a major portion of their own personal wealth tied up in the equity capital of the firm, along with that of senior management and other partners. Accordingly, risk management was a very high priority for all of the firm's key decision makers, and it acted as a powerful and effective brake on the countervailing tendency for bankers to pursue revenues at all costs.

Using this time-tested model, traditional investment banks used to do pretty well for themselves. They ate what they killed, feasting in times of plenty and tightening their belts in times of famine. Because the bankers were the owners of the firm, they kept a pretty tight balance between revenue generation and capital preservation. Accordingly, firm-threatening or -ending mistakes were rare.

But this was not a model suited to rapid growth or global scale. And as the capital markets continued to grow, and the global economy became more connected, the old partnership model of investment banking began to disappear.

* * *

In its place arose large, publicly-owned global investment banks and—with the gradual erosion of Glass-Steagall barriers between commercial and investment banking—large, integrated "universal" banks. Banks funded their expansion with increasing doses of outside capital—other people's money—and merged and acquired their way to greatness with their peers. Unfortunately, with increased scale many of the built-in checks and balances of the partnership model began to break down.

Large public banks did retain much of the partnership compensation model, which deferred ever more of a banker's pay the higher up he got and the more he made. But keeping risk management a central concern for every banker was never a principal reason for this. Instead, banks were much more concerned with preserving cash and attempting to lock up bankers with deferred equity so they could not leave for a competitor. More importantly, deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made. A banker's deferred equity nut began to look more and more like a ball and chain, rather than a direct link and meaningful incentive to control the overall risk of his employer.

Exacerbating this was the professionalization of risk management at large investment banks. As banks got bigger, and their trading books swelled with ever more complex securities, grizzled old traders with big equity stakes in the firm no longer had the experience or the bandwidth to monitor their underlings' trading positions. Instead, professional, dedicated risk managers—who often came from a structuring or academic background, not sales and trading—took over the role of trying to say "enough" or "no" to the hotshot revenue producers. Given the revenue-worshipping culture embedded at the core of every investment bank, such a system was bound to fail, as the big swinging dicks with real skin in the game ignored, bullied, or coopted the sniveling little (equity-less) PhDs sent to rein them in.²

Adding to the problem, the only people with enough skin in the game and the power to do something about firm risk—senior executives—became increasingly beholden to outside public shareholders. Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves.³ They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

Finally, the growth in investment bank balance sheets and the increasingly complex securities either demanded by customers or manufactured "on spec" by revenue hungry bankers led to increasing concentrations of opaque and badly understood risk in many banks' trading books. Market making shaded into speculative trading, which morphed into full-blown proprietary trading (and even internal hedge funds at some banks). Investment banks began to accumulate—apparently without their full knowledge—poorly understood contingent obligations that hinged upon their traditional market-making role as buyer of last resort for securities they underwrote. Risk seems to have been misunderstood and significantly underestimated by almost everybody in the financial markets, but when the shit hit the fan, investment banks were uniquely positioned to have most of it blow right back onto them.

Of course, increasing leverage and lax regulatory oversight played a role, too. But leverage acted as an accelerant and a conduit for contagion across market sectors, and sloppy supervision added to the general haze of ignorance and the thicket of unintended consequences. Neither was the ultimate source of the breakdown in the financial markets. Had they not been present, the fire might not have spread so quickly or so broadly. But make no mistake: the fire would have started anyway, and it still would have burned down a pretty big swath of the financial forest.

* * *

So, what can we conclude from all this?

Well, for one thing, the need for traditional investment banking services—intermediating capital flows and financial transactions for all comers—is not going to go away any time soon. It is simply impractical to imagine a world without investment bankers, no matter how eagerly the torch and pitchfork crowd would love to do so. But it seems to be a somewhat paradoxical business, one best suited to entities which combine extremely aggressive pursuit of revenues with a highly developed aversion to risk. The old partnership system, where the revenue producing bankers were also the owners and providers of equity capital, seemed to work pretty well. The currently much-maligned system of investment banking compensation is a relic of that earlier time, but it does not seem to balance these tensions well in today's huge, publicly-owned global investment banks.

Instead of the old integrated risk model, we now seem to have one where outside investors have high risk tolerance, revenue producing employees have low risk tolerance but cannot effectively influence it, and professional risk managers tasked with controlling it are politically and economically disenfranchised. This is not an unavoidable outcome of the current model, but it certainly makes the whole system far more difficult to manage. Unfortunately, there is absolutely no way to recreate entities the size of Goldman Sachs or Citigroup with purely private partnership capital. Even if you could, I am not sure you could avoid the span of control, scale, and complexity issues bedeviling these enterprises.

One solution, of course, is to shrink investment banks down to a more "manageable" size, whatever that means. The immediate question this raises, however, is whether such smaller banks could perform their systemic function in today's highly integrated global financial system adequately. The next question, if we determine they cannot, is whether we would miss them. My crystal ball is too cloudy to offer an opinion on that one, although I can guess what Matt Taibbi would say.

* * *

In any event, I hope I have convinced those hardy souls who have soldiered along with me this far that investment banking compensation was not the sole source of our current troubles. It is part of the puzzle, make no mistake, but it is not the only piece. Therefore, fixing it and nothing else will not right the ship.

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

Perhaps a solution could be structured which balances all of the competing pressures and strains that the modern investment bank encounters. It would be complicated, involve multiple variables, and require constant monitoring, adjustment, and correction to adapt to ever changing market conditions. It sounds like a fun project for Larry Summers and crew.

Sadly, they never taught multivariate optimization techniques on the savannah when I was coming up in the business. I guess I'll just sit here, gnawing a wildebeest bone, until somebody tells me what to do.

— THE END —

¹ Capital markets activities are the only significant source of firm-wide risk for the traditional pure investment bank.
² This was made worse by the fact that the huge expansion in most banks' capital markets operations during the Great Moderation meant that Capital Markets grabbed the political reins of power from their partners in M&A and Corporate Finance. (Investment banks allocate power based on the Golden Rule: He who brings in the gold gets to make the rules.) Since M&A and Corp Fin bankers enjoy little direct upside from increasing sales and trading revenues but face a lot of downside if sales and trading blows up, they tend to be strong advocates for clear risk limits and controls in the trading book. But the traders were the ones bringing home most of the bacon, so M&A and Corp Fin bankers had no choice but to shut up and view the ballooning risk with increasing disquiet.
³ If Fidelity or another outside investor got worried about Lehman Brothers, they could (at least theoretically) sell all their shares. Dick Fuld and most of the other bankers at Lehman had to watch helplessly as a lifetime's worth of deferred compensation evaporated into thin air when the firm collapsed.

Photo credit for the series: Nathan Myhrvold's 2007 photo essay on lions in Botswana, Africa. Warning: blood, gore, and sex galore. Now do you see the connection?

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part III

I've been to Paris
And it ain't that pretty at all
I've been to Ro-ome ...
Guess what?

I'd like to go back to Paris someday
And visit the Louvre Museum
Get a good running start and hurl myself at the wall

Going to hurl myself against the wall
'Cause I'd rather feel bad than feel nothing at all
And it ain't that pretty at all
Ain't that pretty at all

— Warren Zevon, Ain't That Pretty at All

* *

EDITOR'S NOTE: This is the third installment of a multi-post treatise on investment banking compensation currently in progress. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry; and
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay

This post focuses on risk factors and risk management in the industry.

* *
— Part III: Seed of Destruction —

We have discussed in general terms both the history and evolution of the investment banking industry over the last few decades and the sources and nature of investment banker compensation. Before we can draw some conclusions about how they interacted in the recent financial crisis, however, we must first take a little detour to understand where an investment bank's risk comes from and how investment bankers typically manage that risk.

Historically, pure investment banks were always relatively thinly capitalized entities. This made sense, considering the nature of their business and the risks they undertook. Remember: of the three basic business lines pure investment banks pursue—M&A advisory, securities underwriting, and sales and trading¹—only underwriting and sales and trading carry any material risk to capital. M&A advisory is pure agency business, where the only risk you run is that you put a lot of time and effort into a transaction which does not lead to a fee. The bank puts no capital at risk whatsoever.

In traditional underwriting, on the other hand, there are risks, but they are largely short-term market and liquidity risks. The bank spends a lot of time and energy pre-selling (and usually over-selling) a securities offering to potential investors, so when they buy the securities from the issuer and immediately turn around and sell them to the public, they are assured of a smooth offering. The risk is lowest for what are known as "best efforts" offerings, wherein the bank tells the issuer they will do the best they can to sell the paper, but no promises. The bank does not commit to a particular size or price for the offering, but simply offers to drum up investor demand for a slice off the top. Investment banks love to do these deals; clients not so much.

The alternative is a "bought deal," where the investment bank essentially promises to purchase an entire offering from the issuer at an agreed size and price. In such a deal, it is up to the investment bank to cut a check to the issuer (minus its fee, of course) and then turn around and offload the paper to third party investors. Clients love these deals because they transfer virtually all of the market and execution risk onto the shoulders of the underwriter. Of course, in such circumstances the bank will do as much pre-marketing and pre-selling as it can, and the morning of the sale to investors is usually a frenzied, all-hands-on-deck sort of fire sale. Since it really is putting a substantial chunk of capital at risk, an investment bank tries to price its purchase from the issuer at a level that will comfortably clear the market afterwards. Sadly, bought deals are often found in highly competitive situations, where more than one investment bank is competing for the business, so the winning bank is usually the one which has the most aggressive posture toward market risk (or is the most foolhardy).

Consider as well the fact that it does not take much of an adverse price move to wipe out the investment bank's economics on the deal. If you offer a typical high yield bond at par, and the market moves against you or you have misjudged demand, it only takes a clearing price 2% or 3% below par to wipe out your entire underwriting spread. Given that investment banks normally don't want to end up owning a lot of their client's paper, you can see how nerve wracking it can be to put a couple hundred million of capital at risk to collect a $6 million fee. Talk about picking up pennies in front of a steamroller.

Bought deals were relatively rare a couple decades ago, but they have become increasingly more common over the course of my career. Being able to offer bought deals to large, lucrative, demanding clients like private equity firms funding LBOs has become a competitive requirement for the larger investment and universal banks. Other things being equal, the more bought deals a bank does, the more capital it needs and the more sales and trading capacity it has to have to shovel them out the door, fast. Bought deals are expensive, in terms of capital, people, and risk. They may not be happy about it, but banks painted themselves into this corner. Bought deals increased as a percentage of all underwriting because banks acquired enough capital to do them, weaker banks literally "bought" their way into deals with the practice, and clients flocked to the new product in droves. On Wall Street, the competitive arms race never ends.

* * *

There is also a relatively small risk that an underwriting—either best efforts or bought deal—can go so wrong it needs to be rescinded. Normally this happens because the issuer blows up, fraud is discovered, or the like. In such instances, the bank typically makes the purchasers of the issue whole by buying the securities back from them at the offer price and then tries to collect the money from the issuer. This does happens on occasion, but investment banks try to minimize this risk by performing good due diligence on the issuer before the fact.

More interestingly, there is a longstanding tradition on Wall Street that a bank which underwrites a securities offering has an ongoing obligation to make a market in (i.e., buy and sell) those securities. Usually this is a good thing, as the bank can continue to make money crossing trades in the securities after they have been sold the first time. Unfortunately, it also means the underwriter is the de facto buyer of last resort for such paper. You can see how this can become a nontrivial source of pain for an investment bank when the market is in free fall and Fidelity or Putnam phones you for a bid on $100 million of toxic CDOs you sold them three months ago. It's even worse when everybody calls you up at once, because then you become the market.

Generally, bankers think long and hard before they try to welsh on this obligation. Traders and investors on Wall Street pride themselves on very long memories, and more than one investment bank has lost millions of dollars of repeat business from a buy-side account because they flouted this rule. Unlike M&A and other corporate finance activities—where you have to sign a 30-page contract, confidentiality agreement, and indemnification provision just to go to the bathroom—much of the sales and trading activity that takes place around the world continues to do so on the moral and virtual equivalent of a handshake. Even if most of the CDOs and other toxic securities Wall Street underwrote during the boom did not have explicit investor put options embedded in them—as those sold by Citigroup were reported to have—the implicit put was always there. It was no surprise that most of this shit ended right back on the balance sheets of the banks which underwrote it in the first place.

* * *

Market making—also known as nonproprietary or "customer" trading, in distinction to proprietary trading for the bank's own account—also carries material risk. The real purpose of market making is to provide liquidity for an investment bank's customers: be a buyer when they want to sell and a seller when they want to buy. In exchange for this service, the bank collects a fee which consists of the spread between price paid and price received on the securities it crosses. Unless the security in question trades very frequently in high volumes (i.e., is highly liquid), the bank will likely need to hold a material amount of it in inventory, in its trading book. This inventory must be supported by capital, and it poses nontrivial market and liquidity risk to the bank.

The more a bank treats a particular trading book like a pure market making facility, the fewer securities it will typically hold in inventory. That way, if the market price plunges, its mark-to-market loss will be smaller and more manageable, and it will be easier to sell the (small) losing position to another buyer. The real risk in this situation is a market stoppage, or complete evaporation of liquidity. If trading in a security completely stops, not only is the bank stuck with any securities it has in inventory, but the true market price either becomes unknown or severely discounted from the last trade. Big mark-to-market losses result, and capital takes a nasty hit. Fewer pennies, bigger steamroller.

Finally, as I mentioned previously, market making can shade almost imperceptibly into proprietary trading and speculation. The more it does so, of course, the more an investment bank's risk profile increases in relation to both market (or price) risk and liquidity risk. While investment banks have always prided themselves on their market sense, derived from their privileged position astride the global financial markets, it is a different kettle of fish entirely to surf the ebb and flow of the market to capture nickels and dimes than to build and hold concentrated investment positions over extended periods of time. The sorry history of most of the internal hedge funds set up within investment banks over the past few years is proof of this.

* * *

Now, what does this tell us about how investment banks have typically gone about managing risk?

Well, for one thing, you need to understand that investment bankers have traditionally viewed their business as a flow business. That is, for most of its history, investment banking has focused on facilitating the investment and capital allocation transactions of others. They are not in the business of accumulating assets, inventing products, building businesses, or indeed building anything. They are pure agents, and their objective is to get paid to help other people do things with capital and markets.

Also, as capital markets intermediaries par excellence, investment bankers believe in their very bones that every market they participate in—M&A, equities, bonds, commodities, derivatives, etc.—is deeply and irrevocably cyclical. Each of these markets goes through repeated cycles of boom, bust, and inactivity.² Hopefully, an investment bank has adequate capabilities and market position in a selection of markets, so it can enjoy the boom in one or more sectors while it struggles through a bust in others. But for individual investment bankers, who nowadays tend to be highly specialized and therefore difficult to reassign to other duties, that means you have to be ready to rumble when the time is ripe. Most investment bankers can expect only so many boom cycles in their chosen specialty during their career, so they tend to go whole hog when they happen.

Not for nothing is the informal motto of my industry "Make hay while the sun shines."

The entire industry compensation system is designed to manage this cyclicality, too. Bankers are paid fixed salaries which are a small fraction of their expected average pay, with the balance made up of variable incentive compensation, otherwise known as the "bonus." This does several things. For one, it reduces fixed labor cost to a bare minimum, in case results for the year—measured firmwide, by division, by group, or by banker—don't pan out. For another, it encourages bankers to work as hard as possible to make lots of revenues, since there is no theoretical upper limit to a senior investment banker's compensation. Given that healthcare banking may only boom once every five years, for example, the firm wants to make sure the banker who has already booked $75 million in revenues keeps trying to get another $25 or $50 million more. Finally, the fact that a huge portion of a banker's wealth is tied up in stock of his employer gives him an important incentive to keep trying for revenues even in a down year.

Having a seat at the table the next time a boom comes around gives a banker a very valuable option. Bankers work hard to hold onto a position at their firm in bad times, and they work like the Devil to harvest revenues when the sun is shining. Given the intensity of competition and the stakes at hand, investment bankers rarely tend to think in terms of a "career." Instead, they focus deal to deal, and on booking the next trade. This is true in every division of the modern investment bank. When the revenue salmon are running, you don't stop to count how many you have caught, worry whether you will get ill from eating too many, or wonder when they will stop. You just keep fishing.

Investment bankers don't do the future well.

* * *

For some businesses, like M&A and best efforts underwriting, this is where the story ends. Bring in a good deal, and you get paid. Lose it, or mess it up, and you may get dinged, or even fired, but it will not seriously threaten the firm.

It's different in sales and trading, where bankers commit real firm capital. Mistakes can have huge effects, and a single trader's mistake can wipe out half the bonus pool for his division or cause a net loss for the firm. There, traditionally, traders managed themselves. That is, a grizzled old veteran who cut his teeth trading XYZ bonds was the guy who monitored the trading book and risk positions of the junior trader tasked with that job today. In the old days, when most investment banks were partnerships owned by their employees, this made for very effective risk control. No crusty old bastard who has given 30 years and three marriages to his employer is going to let some wet-behind-the-ears tyro blow his retirement account. Even now, with atomized public ownership diluting investment bankers' stakes in their own firm, you can make an argument this is a decent system. Who better to understand the risks than a guy who sits on top of the market and has the best view of short-term opportunities and threats?

But monitoring markets in real time this way has serious limitations as a form of risk management. It was sufficient for traditional market making and early proprietary trading, when positions held were small, turnover was fast, and trading books were relatively uncomplicated. You didn't put on or maintain a position you couldn't close out in a couple hours or days, and the head trader personally understood all the securities in his underlings' books backwards and forwards. Nowadays, that is not the case, so risk management has become professionalized and separated from the sales and trading function. This helps preserve objectivity, but at the price of introducing a more serious problem.

For it should be clear to you by now that the most important people in an investment bank are the people making the money. The revenue producers have always held the power and authority; staff are an afterthought. Due to the cyclical nature of their markets, their incentive compensation structure, and the aggressiveness and drive of the people they attract, investment banks have always worried about revenues first, second, and third. Efficiency, resource management, and risk control were always far down the list.

And while this may have worked when span of control was short and revenue producing bankers' incentives were completely aligned with active risk control (because it was their capital they were risking), it clearly has not worked in today's environment. Forget about whether risk managers even understood the risks their firms were taking over the last several years. For all I know, they may well have.

What I do know is that when investment banks got big enough and bureaucratic enough that risk management and revenue generation could be separated, the wheels began to come off the bus. When senior executives—almost all of whom, by the way, came from revenue producing backgrounds, not risk management—no longer had direct responsibility for risk control, the importance of risk control diminished at their firms. Sure, lip service continued to be paid, but that's all it was for most of them. Risk managers were co-opted, captured, or ignored by the very revenue producing divisions they were supposed to monitor and control. As a capper, the nature of risk assumed by many investment banks changed too, to long-tailed, multi-period risk from structurally illiquid securities—exactly the opposite of the type of securities investment banks had a long history of understanding and managing well.

It all had to end in tears, and it did.


Next and last: Part IV: Darkness Calls ...


¹ A clarifying word about terminology. As a rule, investment bankers are promiscuous, sloppy, and lazy in the terms they use to describe their own business. Sadly, I am no exception. In part, there is a good reason for this, since our business is defined by how it straddles different customer universes and different market-related activities. "M&A Advisory" and "Corporate Finance" typically describe the divisions that work with corporate clients to do deals and issue securities. Sometimes this division is called "Investment Banking" by (self-described) purists, but many people also use that term to describe everything an investment bank does. "Capital Markets" is the formal term of art for the division which services the needs of institutional investors, but it is often called "sales and trading," too. Sales and trading is where you find institutional salesmen, market makers, proprietary traders, securities structurers, and the like. Complicating the picture, Corporate Finance and Capital Markets cooperate to underwrite new securities for issuers, with Corporate Finance usually sourcing the deal and Capital Markets executing it. I could go on, but I notice your eyes are beginning to droop. Alles klar?
² By which I mean cycles of activity, not price level. Investment bankers don't make money when markets go up, at least not directly. We make money when people do deals, issue paper, and trade securities. While there is some correlation between these activities and upward market moves, they are not tightly linked. In fact, on the trading side of the business, investment banks tend to make the most money when markets are flopping around like a dead fish; that is, when volatility is high.

Photo credit for the series: Nathan Myhrvold's fascinating 2007 photo essay on lions in Botswana, Africa. Warning: as Nathan says, "some of the photos are a bit gory, and one shows explicit lion sex." Yawn. If that's explicit, I Dream of Jeannie should be rated R.

© 2009 The Epicurean Dealmaker. All rights reserved.